Active vs Passive Investing – Are There Times When Actively Managed Funds Can Actually Be A Good Thing?

I take the time to grab a cup of coffee, sit down in front of Vanguard’s website, and review all our current and potential investments.

Exciting? I know … But it has to be done.

What is it I’m looking for exactly? Obviously the opportunity to make more money!

More specifically I’m combing through the performance figures and seeing what’s out there.

But wait! Aren’t I just wasting my time? I thought all the “smart” investors just buy a simple index fund that follows the S&P 500? That’s the big secret behind active vs passive investing, right? Set it and forget it! Couldn’t I just do that instead?

Well, I could …

… but is that really the smartest thing to do?

What Are Active Funds Trying to Do?

Actively managed mutual funds are not always quite the villainous used car salesmen that people make them out to be. The whole reason they exist is because a fund manager somewhere believes he/she can achieve valuable goals that a regular index fund would not ordinarily accomplish.

What might those goals be?

Higher returns

Diversification mixture

Exposure to markets that the S&P 500 doesn’t reach (i.e. foreign)

Exposure to other asset classes (small-cap, mid-cap, etc)

Other kinds of assets (bonds, cash, etc)

A certain investment strategy or philosophy that the manager believes in

Investments in companies that fit a certain type of philosophy

And my personal favorite:

Defense

But John Bogle Says Passive Funds Are Better!

“Plus it goes against what all the cool personal finance bloggers say!”

This is a long standing belief between active vs passive investing has long been advocated by many professional and amateur investors alike. The theory was made popular by the founder of Vanguard John Bogle. In his book “The Little Book of Common Sense Investing“ as well as other publications, Bogle widely supports the advantages of using passively managed index funds over actively managed ones.

While he makes some valid points, I think of the things that often gets misinterpreted in Bogle’s message is this:

An actively managed fund will never be able to beat the long-term returns of a passively managed index fund. (FYI – Depending on whether you follow the Dow Jones or S&P 500, that figure is somewhere between 8 and 10% per year).

Where Active vs Passive Investing Can Make a Difference:

Suppose we Bogle’s statement to be true. Suppose I DON’T CARE to beat this 8 to 10% figure, and I accept that is the maximum average return I could ever hope to see. So what then?

You pick your investments based on two criteria:

How big of returns we get net of expenses

Risk

Notice how the Bogle’s statement above doesn’t say anything about the risk or security of those funds. What do I mean by that?

Everyone knows that stocks (as well as all investments to a degree) go up and down. Sometimes the price shoots up really high. Sometimes the price drops down really, really low. That’s the risk you take on as an investor.

So if we know that our returns are “fixed” at this upper limit of 8 to 10%, then which would you rather have (assuming both come out the same in the end):

A fund that fluctuates widely up and down?

A fund that fluctuates modestly up and down?

If you said No. 2, then you’re with me. And you need something more than a passive index fund.

Why Defense Matters:

You might ask:

If both funds end with the same returns, then what does it matter? After all – aren’t we all supposed to be investing for the long term?

Yes, that’s true.

All of this largely depends on your investment horizon. If you have 30 years or more to invest, then who cares which one you invest in.

But let’s look at a very real scenario.

Suppose you retired tomorrow and needed to start making withdraws from your money. If you have a million dollars and use the 4% rule to withdraw money, then you’ll get $40K. And you’ll expect to withdraw an inflation adjusted $40K every year thereafter.

But wait! Oh no! The stock market crash of 2008 happened all over again and your investments dropped by 50%! Now your million dollars in savings is only $500K. If you continue this $40K, now you’ll be withdrawing 8%! And that’s surely going to drain your savings!

So now you’re stuck with risking sabotaging your savings or reducing your living expenses by half! Neither of these are very good.

That’s where a defensive strategy could have been beneficial. Say instead of dropping by 50%, your accounts only dropped by 25%. While that’s not great, you’re in a much better position than you were with a 50% drop in savings.

How do you feel when you see a 50% drop in your 401k? Good? Or like you want to jump off a bridge?

I remember in 2008 when stocks crashed so many of my co-workers decided to move all of their savings into cash investments. “Better to preserve what we have left than to lose it all” was their logic – even if it was flawed.

So why torture yourself? If you can find funds that have the same returns as passive funds, but carry less risk and fewer fluctuations in prices, then I say why not!

Consider one of my favorite balanced funds: The Vanguard Wellington Fund (VWELX) versus the S&P 500 index. Though the Wellington fund is made up of both stocks and bonds whereas the S&P 500 is all stocks, both have similar returns. But take a look at these returns and tell me which one you would feel more comfortable with:

Notice how the Wellington fund return is much more steady than the common stock index. If you were retired, your money would have greater potential to not run out. Even if you’re not retired, you’d probably freak out a whole lot less when your fund doesn’t decrease by as much as everyone else’s.

Thus you can see there would be some benefit to using an actively managed fund.

You Be the Judge:

This post should not be interpreted as saying that all passive funds are bad or that all active funds are better. Rather this post is simply trying to get you to think a little differently about active vs passive investing.

You can bet that passive funds will still play a very important role in my 401k fund! Why? Because when I look deeper into all the actively managed funds offered by my employer, I’m not impressed. The passive one beats most of them.

But remember – it’s up to you how you want to build your investments. If you have no problems with the risk or see no reason to stray, then pick the passively managed fund. But if your investment strategy or tastes call for something a little bit more defensive, then don’t be afraid to look beyond the plain vanilla flavor of an index fund. It could mean the difference in thousands and thousands of dollars later on in life.

Readers – Where do you weigh in on the active vs passive investing debate and why? Do you see how in some instances an actively managed fund might actually help more than it hurts your portfolio?

Comments

I 100% agree that there’s a place to be defensive. After all, 30% of our personal investments are in Treasury Bonds. But to be honest I don’t think that has anything to do with the active vs. passive debate. You can just as defensive with index funds as you can with active funds and not have to sacrifice the other benefits that index funds give you. Maybe you could explain to me what I’m missing here.Matt Becker recently posted..A Step-by-Step Guide Through the Process of Actually Buying Life Insurance

Can you? If you could invest in just one mutual fund (such as the two I present here), would you really be safer with the index fund?

I understand you could invest in multiple types of index funds (one’s that follow large-cap, ones that follow bonds, ones that follow other market sectors). The Lifecycle and Target Retirement funds do that for you. But even those may have more ups and downs than an actively balanced fund that invests in several different types of funds.

Why would you assume you can only invest in one fund? Unless you’re talking about someone just starting out who can’t meet the minimums for multiple funds, then that’s a false choice.

But even for that person who only has enough money to meet the minimums, I don’t see why you think an active balanced fund is better than an indexed balanced fund. The choice you present here is an S&P 500 index fund vs. Wellington, which is really a faulty comparison because they’re meant to do different things. A better comparison would be Wellington to Vanguard’s Moderate Growth LifeStrategy fund, which keeps essentially the same asset allocation. Now, in the case of those two specific funds, I would personally prefer the LifeStrategy because it’s all index funds, but Wellington is a fine choice as well. But the extend that to a broad active vs. passive conclusion is I think dangerous. Wellington is EXTREMELY low cost for an active fund, which is really where it’s benefit lies. Most active funds are not so inexpensive.

But to step back, I still don’t see how this is in any way a question of active vs. passive. This is a risk tolerance question, one that can be answered completely independently from active vs. passive. Whether you choose active funds or index funds, you can separately choose to have more or less allocated to stocks, bonds or whatever. I just don’t see the connection here.Matt Becker recently posted..Struggling to Find Your Motivation? How About Creating it Instead?

The premise here is simply not to dismiss all actively managed funds only because they are active. I’m trying to fight one of those financial “one size fits all” mantras that I get so tired of hearing people repeat without clearly understanding the implications of their choices.

This is not at all too suggest that ALL active funds are better than passive ones, or vice versa. Rather that in certain circumstances, the actively managed one may produce 1) marginally better returns and 2) relatively lower risk from the fluctuations of the assets it holds.

You say that to compare the S&P 500 index vs Wellington is false, which I can understand since they represent different collections of assets. However I’m afraid that this kind of comparison happens all the time when common investors ignore the fund’s holdings and will simply delve in only because “they heard passive funds were better”.

BTW – that was my point in my previous comment in comparing only one fund against another. Of course investors are welcome to invest in anything they want, and any combination of choices. But take the perspective of a young investor with not very much to start out (which is actually most of America). Often they might open an account with just one mutual fund, and it could be years before they ever update or add to it. Again, do they blindly pick an index fund because they heard those were better, or do you dig a little deeper into your other choices and consider them all; passive or active?

Even in your example, I would choose the Wellington over the Life Strategy fund because when I compare the two the Wellington has performed much better over a 10-year stretch. The Wellington is a fine example of when an active fund can trump the passive choices; hence the active vs passive connection.

I think there are a few different points here that are kind of getting muddled up. Here’s how I see them.

The first is your comparison of the S&P 500 index fund to the Wellington fund and the argument that the Wellington fund provides value in that it’s more defensive. That’s a valid argument but it’s 100% an asset allocation argument, not in any way related to the active vs. passive debate. I couldn’t agree more about the importance of asset allocation and I think it’s one of the most important decisions an investor makes. But again, this has nothing to do with active vs. passive. It doesn’t argue for or against either.

The second is your point that the active vs. passive debate is not black and white, which I completely agree with. There are good active funds and there are bad index funds. The big difference is that it’s easy to spot a good index fund (low tracking error) while it’s very difficult to spot a good active fund (low cost is a good start, but not sufficient). Given that one is easy to identify and the other is very hard, to me the choice is pretty simple.

Finally, you say you would choose the Wellington over the LifeStrategy fund. I won’t argue with the choice as I think there are many factors that could sway a person one way or the other. But I will disagree with the logic of using 10 year returns as the deciding factor. No rational person has ever made the argument that index funds will outperform everything over every given time frame. There will always be strategies that outperform an index strategy. But what IS shown is that the probability of the same thing outperforming over multiple consecutive periods is very low. It does happen, but you’re playing against the odds if you’re using past performance as your guide.

The S&P500 vs Wellington is indeed related to the active vs passive debate on many fronts: returns, defense, etc. I do agree that asset allocation is of course a part of the selection factor and goals when selecting one or the other. And you’re right that a better comparison would probably be to compare the Wellington vs Life Strategy funds (which are more similar in their asset allocation). But you have to consider that all factors are on the table when an investor is to select from the myriad of investments options that are available.

Let’s say I’m just starting out a new IRA with $3,000, and I need to pick a mutual fund to invest in. Do I go blind and pick the passive S&P500 because I heard that’s what I’m supposed to do? Do I put a little more thought into my selection and pick the Life Strategy but again stay away from active funds because I heard they’re no good. Or finally do I weigh all my options? Passive, active, Wellington, whatever I find that fits my return and defense goals.

My previous comment was not to suggest that the 10Y return is only factor in choosing the Wellington vs Life Strategy. Just like in all active vs passive fund cases, you select a fund based on invest goals, risks, asset allocation, past performance, expenses, and many other factors.

By definition, a passive index fund is simply a market average – meaning some active funds do better and some funds do worse. Over time most of the returns even out. But not all of them are worse off than the index fund. Some have slightly better returns. Some perform basically the same but offer less fluctuations in the returns. The astute investor will consider all their options and not simply default to the index fund option every time.

I think you can make index funds of your own risk variety. 50% in S&P 500, 50% in Total Bond index, etc. The other option is to just pick a fund that does that for you like one of the Vanguard Life Strategy funds. Luckily, with Vanguard, the fees are really low either way.Kim recently posted..Thoughts About Turning 40

MMD, thanks for the post. I am like many, I just purchase index funds because that’s what everyone says to do. You have given me something more to think about! I would be curious to hear your reply to Matt Becker though, that is an excellent question from him.Jon @ Our Fine Adventure recently posted..Freelance Blogging

In his book, Common Sense on Mutual Funds, John Bogle makes the case that investors only need 1 fund, a balanced fund about 60 to 65% stocks and 30 to 35% bonds…and he likes an index balanced fund…having invested for 30 years, I can understand his thought based on the statistical returns of the market he cites and the market returns the last 30 years…if I had invested in just 1 balanced mutual fund and bought a few stocks along the way as I have, I would be just fine…I can certainly understand the thought an investor really just needs 1 balanced fund…and Vanguard Wellington is a balanced fund with low turnover which I have in an IRA…not that it matters but I have index funds in 401k, and in 2 taxable accounts, I have 5 index funds with Vanguard and 2 actively managed funds at Dodge and Cox….so put me in the camp of index funds and balanced funds at low cost fund companies….I’m sure John Bogle made the point once you have low cost funds in your 401k and hopefully IRA, the key is regular contributions and to leave the money alone unless you need it for roof over your head or food on the table….thanks for the article.

All good points Chris. John Bogle was pretty amazing. His philosophies on investing made it statically possible for virtually any novice to, at a minimum, capture the average market return. That’s a powerful strategy, especially for those who know nothing about investing. It basically gives them the fast-track to capture a long-term average annualized 8% return. I find this to be a good baseline from which all other investments can be judged.

I think there can definitely be a role for actively managed funds to get access to more “exotic” or “niche” exposure that’s hard to otherwise access. International stocks, country specific exposure, small/micro caps. It’s hard to do this on your own cost effectively and passive index products generally aren’t so readily available for these types of categories. An actively managed fund is an excellent way to access this exposure if you can do so cost effectively.Integrator recently posted..What’s your investment philosophy?

Entirely true. Indexes are by design setup to capture market averages, but not necessarily certain flourishing spectrums of those markets. Do we ignore those positives simply because they are not part of a traditional index fund? Absolutely not. This is when certain actively managed funds can add some strategical value to the overall goals of the portfolio.

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